Deconstructing ESG scores: How to invest with your own criteria

BIS Working Papers No 1008

50 Pages Posted: 6 Apr 2022

See all articles by Torsten Ehlers

Torsten Ehlers

Bank for International Settlements (BIS)

Ulrike Elsenhuber

Bank for International Settlements (BIS)

Anandakumar Jegarasasingam

Bank for International Settlements (BIS)

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne); Swiss Finance Institute

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2022

Abstract

Environmental, Social, and Governance (ESG) scores are the main tool for asset managers in designing and implementing ESG investment strategies. They amalgamate a broad range of fundamentally different factors, creating ambiguity for investors as to the signals of higher or lower ESG scores. We explore the feasibility and performance of more targeted investment strategies based on specific categories by deconstructing ESG scores into their granular components. First, we investigate the characteristics of the various categories underlying ESG scores. Not all types of ESG categories lend themselves to more targeted strategies, which is related to both limits to ESG data disclosure and the fundamental challenge of translating qualitative characteristics into quantitative measures. Second, we consider an investment scheme based on the exclusion of firms with the lowest scores in each category of interest. In most cases, this targeted strategy still allows investors to substantially improve the portfolio headline ESG score, with only a marginal impact on financial performance relative to a broad stock market benchmark. The exclusion results in regional and sectoral biases relative to the benchmark, which may be undesirable for some investors. We then implement a “best-in-class” strategy, based on excluding firms with the lowest category scores and reinvesting the proceeds in firms with the highest scores maintaining the same regional and sectoral composition. This approach reduces the tracking error of the portfolio and slightly improves its risk adjusted performance while still yielding a large gain in the headline ESG score.

Keywords: Sustainable investment, ESG ratings, ESG investing, Negative screening, Best-in-class screening

JEL Classification: G11, G24, M14, Q01

Suggested Citation

Ehlers, Torsten and Elsenhuber, Ulrike and Jegarasasingam, Anandakumar and Jondeau, Eric, Deconstructing ESG scores: How to invest with your own criteria (March 15, 2022). BIS Working Papers No 1008, Available at SSRN: https://ssrn.com/abstract=4058612 or http://dx.doi.org/10.2139/ssrn.4058612

Torsten Ehlers (Contact Author)

Bank for International Settlements (BIS) ( email )

Office for the Americas
Mexico City, 11580
Mexico

HOME PAGE: http://https://www.bis.org/author/torsten_ehlers.htm

Ulrike Elsenhuber

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Anandakumar Jegarasasingam

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne) ( email )

Extranef 232
Lausanne, 1012
Switzerland
+41 21 692 33 49 (Phone)

HOME PAGE: http://people.unil.ch/ericjondeau/

Swiss Finance Institute ( email )

40, Boulevard du Pont-d'Arve
40, Bd du Pont-d'Arve
1211 Geneva 4, CH-6900
Switzerland
+41 21 692 33 49 (Phone)

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